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How Decentralized Exchanges Make Bitcoin More Resilient (and Us More Free)

Governments and central banks all over the world are gradually warming up to the idea of leveraging the unique advantages offered by blockchain technology — low-cost transactions permanently recorded in tamper-proof distributed ledgers — to modernize their financial systems.

According to sources familiar with the matter, the Indian government is considering a proposal to introduce its own cryptocurrency similar to Bitcoin, Business Standardreported last week. The new cryptocurrency would be managed by the Reserve Bank of India (RBI) and could be called “Lakshmi.” Other central banks are exploring similar ideas.

Of course, that will take time, and the governments are unlikely to support important features that make Bitcoin and other cryptocurrencies appealing to end users, such as mining and near-anonymous, paperwork-free transactions. Therefore, Bitcoin, Ethereum and at least some altcoins are likely to continue to prosper.

But some governments, such as China’s, don’t seem to like that. After banning Initial Coin Offerings (ICO), the Chinese government is moving to close the cryptocurrency exchanges operating in the country.

It appears that governments love blockchain technology but hate Bitcoin itself, as well as other “crypto-anarchic” digital currencies. Some governments are reacting in a panic because they are starting to realize that they can’t stop Bitcoin from becoming an alternative to their monopoly on currency, both as a means of exchange and a store of value. Centralized cryptocurrency exchanges are especially vulnerable, and other governments could follow China.

A Role for Decentralized Exchanges

Decentralized exchanges that use peer-to-peer (P2P) technology to bypass the need for a central exchange provider are an interesting option that could make blockchain-based digital currencies much more resilient.

Decred recently introduced atomic swap support for exchange-free cryptocurrency trading, showing that, at least for crypto-to-crypto trading (for example, exchanging bitcoin for litecoin), it’s perfectly possible to operate without exchanges. However, this doesn’t solve the problem of crypto-to-fiat and fiat-to-crypto trading, which is arguably of top concern for cryptocurrency users.

“Atomic swaps are the first sign in a new wave of decentralization,” Decred project lead Jake Yocom-Piatt told Bitcoin Magazine. “As trustless exchanges between pairs of cryptocurrencies, they offer new efficiencies for users who don’t need the formality of the traditional exchanges. It is going to be interesting to see how the trend develops, since for larger and more complex transactions with fiat currencies, LocalBitcoins and established exchanges are still the place to be.”

Coinffeine is developing an open-source, P2P Bitcoin exchange platform that will enable users to buy and sell bitcoins securely and anonymously, without having to rely on a centralized exchange. The project seems promising, but it hasn’t shown much activity recently.

Bisq (formerly Bitsquare) provides an open-source desktop application that allows users to buy and sell bitcoins anonymously in exchange for national currencies or alternative crypto currencies. To protect users from fraud, both traders are required to place security deposits into a multisig-based escrow mechanism; the deposits are refunded after a trade completes. To handle disputes, Bisq features a decentralized and open arbitrator system. Bisq is now preparing to launch a decentralized autonomous organization (DAO) and an ICO for its BSQ token, a colored coin on the Bitcoin blockchain.

Decentralization and Freedom

Bitcoin Magazine reached out to Bisq developer Chris Beams for comments on government attacks on cryptocurrency exchanges, likely attack vectors and the impact of decentralized exchanges. Beams also offered a passionate and forceful defense of individual liberty against government over-interference.

“The panic has to set in at some point,” argued Beams. “But it will do so at different times for different governments, and will produce a range of responses from them when it does. I don’t think China’s recent actions — whether they’re the product of panic or something more strategic — will necessarily cascade into similar actions in the U.S. or Europe. Shuttering all exchanges by diktat is the kind of textbook totalitarianism the world has come to expect from China, but a similar attack wouldn’t work as well in the U.S. Even if it would, it would be a blunder for the U.S. to attack Bitcoin with such a blunt instrument. It would be suboptimal, a bad use of available resources. It would strengthen the decentralized exchanges that already exist and it would incentivize the creation of better, even more censorship-resistant ones.”

According to Beams, the U.S. in particular has much more effective tools at its disposal, especially Know Your Customer (KYC). The U.S. government forces nearly every centralized exchange, on day one of operation, to collect personal identity information about their users and to correlate trading activity with those identities.

Beams explained that U.S. corporations tend to take compliance seriously and actually do cooperate with these rules, meaning that U.S. regulatory agencies have, in principle at least, access to enough information to de-anonymize a large and growing percentage of all Bitcoin transactions. And plausible traceability of transactions is all they need to keep the threat of tax collection in force.

“If I were the U.S., I’d be ushering new Bitcoiners through the Coinbase cattle gate just as fast as they can be prodded,” said Beams. “If I were the U.S., I would have long since concluded there’s nothing fundamental I can do to stop Bitcoin itself, so if I can’t beat ’em, I’ll at least make sure I can continue to tax ’em.”

The recent John Doe summons delivered to Coinbase by the IRS shows that KYC is the attack vector of choice for the U.S., which could result in billions in taxes reported by people who fear that their Bitcoin activity can be audited. KYC appears to be a much more effective long-term attack vector than heavy-handed shutdown orders.

“So yes, by all means, let’s bring on the decentralized exchanges,” said Beams. “But they’d better be really and truly decentralized because if a government can stop them, they will — at least once they get big enough to become worth the effort. The attack vector with decentralized exchanges won’t be KYC, though, because any decentralized exchange that implements KYC will instantly be abandoned by its users.”

The attack vector for decentralized exchanges, said Beams, will be “the good ole four horsemen of the infocalypse.” In other words, decentralized exchanges will be vilified as tools for drug dealers, terrorists, pedophiles and money launderers.

“It’s the same script every time a government is interested in talking people out of their own freedoms. This attack vector won’t work for the exchanges that have achieved escape velocity levels of decentralization, but it may stop some and will make life difficult for others.”

Beams suggested that the only way to really stop decentralized crypto-fiat exchanges would be to outlaw Bitcoin trading altogether. “This would force people to think twice about every trade, and to consider whether their counterparty might be an agent, which would result in a profound chilling effect.”

However, he thinks that this sort of heavy-handed attack seems unlikely to be attempted in the U.S. or Europe because there are just too many vested interests in Bitcoin now. It’s more likely that the authorities will continue to insist on KYC, tolerate compliant centralized exchanges and demonize the decentralized ones.

“With all that having been said, I’m actually optimistic,” concluded Beams. “Attacks by state actors — real and threatened — are making every part of this ecosystem stronger. Bitcoin has proven itself anti-fragile as hell thus far, and by the time all the battles have been waged, what will emerge on the other side are alternatives to existing financial institutions — money, banks, exchanges and all the rest — that are actually better in every way than their traditional counterparts.

“We are being forced by the threat of state violence to design crypto-economic systems with the highest degrees of security, privacy and censorship resistance baked in from the protocol level up. That very pressure is what is propelling these solutions forward, I think, into a bright future of genuine financial freedom for people. I wouldn’t be working on this stuff if I thought otherwise.”